Moneyball without the ball

Impac Mortgage: Out of Nowhere

by Lsigurd on August 19, 2012

Sometimes you have to act before you know the whole story.

I’ve been on holidays all week and have had pretty limited access to the internet. I’ve checked my emails maybe once a day at most. On Tuesday night I checked and I noticed the following google alert (by the way I would highly recommend using google alerts for all key words and company names. Its an invaluable tool).

I had never heard of the company but I’ve been looking for other ways of playing the origination and servicing industry, especially through smaller companies. So I read the earnings release.

50 cents per share earnings in the second quarter. Most of the earnings appear to be coming from plain vanilla mortgage origination (same business as PHH). The company almost doubled origination revenue year over year. They also hold on to their servicing rights and appear to be growing their servicing portfolio.

Then I check the stock price on yahoo. The stock had a $2.30 close before the earnings release.

Wait a minute. This company just earned 50 cents in the quarter and its trading at $2.30 per share?

Well before I went to bed I thought about what I needed to clarify before the market opened the next day if I were going to buy the stock. I needed to make sure that the share structure was what it appeared. I needed to make sure that the earnings were legitimate (that they were coming from mortgage origination and not from a one time mark to market valuation change). And I needed to make sure that there wasn’t some sort of debt or financing issue (for example some sort of GSE putback overhang) that would put the company close or perhaps over the precipice.

I read through the 10-Q, which was released with earnings, and I read through the 10-K risk factors. I didn’t see any red flags. So I took the optimistic attitude that maybe this stock was simply mispriced. Maybe it was like all the other mortgage related stocks and the mortgage industry itself and it was just hated to the point where it no longer reflected reality.

First thing in the morning before everyone woke up and I had to get off the computer (it was a vacation after all) I bought some stock. I took a 1% position in each of my portfolios, including the one followed here:

By the end of the day, the stock was trading over $4.

I give this history in part because I hate to write up a stock after its had a run like Impac has. I’m sure its going to sound to some like a pump and dump or an unlikely piece of luck. Yet this blog is about the stocks I’ve bought so that’s what I have to write about and that’s what I’m doing.

As well, specifically regarding the outlook of Impac Mortgage, even though the stock has run up a rather ridiculous 100+ percent in the last 4 days, I think it may go a lot higher. If I’m reading it right and not missing anything (which keep in mind I very well could be), the stock has room to run. After all this was a $250 stock in 2005 and even after the run up, the market capitalization is a miniscule $30 some million dollars (though there are additionally some preferred’s outstanding). I’m not just talking the talk. I doubled my position on Friday at $4.26.

So with a word of warning that any stock that has risen 100% in less than a week should be carefully considered before buying, let’s take a look at what the company does.

On to the company…

The story here is a simple one. Impac is a mortgage originator that has been growing it origination volumes substantially for the past year, and that growth has finally reached the inflection point where it has become profitable.

The company originates mortgages through retail, wholesale and correspondent channels. A breakdown of origination volume by channel for the second quarter is illustrated below:

The company has developed a significant retail platform. Retail lending is when the company deals directly with the borrower, as opposed to wholesale and correspondent lending where they are acting through independent brokers and correspondents who are originating the actual loans which are then sold to them.

The retail business is more often the higher profit business (because there is no middle man taking a cut) but it also requires more up front capital and fixed costs as you have to develop the infrastructure, the marketing, the people and the relationships required to interact with the borrower directly. These higher start-up costs were at least partially responsible for the losses incurred in previous quarters. The company made the following statement with respect to this in the year end 10-K:

In 2011, the mortgage lending operations has been successful in increasing its monthly lending origination volumes to be in excess of $100 million. However, although the mortgage lending revenues increased in 2011, expenses associated with the mortgage lending activities significantly increased also. The increase in expenses was primarily due to start-up and expansion costs with opening new offices, hiring staff, purchasing equipment, investing in technology and the supplemental default management team as discussed above. Specifically, as the Company attempts to build a purchase money centric platform with a significant amount of retail originated loans; the related start-up costs for this type of origination platform will be higher than a wholesale refinance focused mortgage operation. In addition, the Company has made small investments in proprietary technologies that will further support our expansion of retail originated purchase money mortgages along with more competitive recruitment of realtor direct loan officers. The Company believes this is the right strategy in the long term as interest rates on mortgage loans are expected to rise in the future, which will greatly reduce the percentage of refinance transactions to more historical percentages. In order for the mortgage operations to achieve profitability, we will need to (i) increase overall origination volumes, (ii) improve lending revenues by originating a higher percentage of retail loans and products with wider margins and greater loan fees and (iii) reduce lending operating costs through increased operational efficiencies, or some combination of them.

While in the second quarter most of the growth was from the wholesale channel, future growth is expected to be driven from retail.

Second quarter volumes in the wholesale and correspondent lending channels led to significant volume increases over the first quarter; however, retail expansion during the second quarter is expected to lead to a corresponding increase in retail production during the 3rd quarter. Retail production is also expected to increase from the opening of the previously announced Reverse Mortgage operations.

Moving on to margins, Impac’s margins on mortgage lending look comparable to other companies I follow. The company booked mortgage lending gains and fees of $15.1 million on $531.9 million of loans originated. That is a total gain of 283 basis points. To compare, PHH recorded a total gain on loans of 308 basis points in the second quarter. Nationstar meanwhile recorded gain on sale of 306 basis points.

The company also earns money from mortgage servicing, and they have been growing their servicing portfolio every quarter. I appreciated the company’s comments that they saw opportunity in holding on to the service rights of the mortgages they are originating given the ultra-low rates and high quality loans that are being written.

Excel expects to continue building its mortgage servicing portfolio as management believes a servicing portfolio of agency loans during a period of low interest rates and high credit quality focus is a good investment for the Company.

It’s the same line I’ve been saying for months now.

The company hasn’t been reporting the total balance of loans serviced for very long, but below the increase over the last 3 quarters is illustrated:

The company hires a subservicer to perform the servicing activities. Assuming 25 basis points for the servicing fee and 7 basis points going to the subservicer, the company stands to pull in around $2 million in servicing revenues per year.

All of the loans originated and serviced are conforming, meaning they are being sold to Fannie Mae, Freddie Mac, or Ginnie Mae.

Things to be concerned about…

With this all said, the company does have some hair.

For one, they do not do a very good job of explaining their mortgage lending revenues. While PHH and Nationstar both provide enough information to determine what they are valuing the capitalized servicing rights at, I can find no way of doing that with what Impac provides.

Second, the company appears to mark to market just about everything, including their long term debt. As noted in the 10-Q:

…long-term debt had an unpaid principal balance of $70.5 million compared to an estimated fair value of $12.0 million

Huh? I don’t know if I am misunderstanding this or what because I have never seen a company mark to market their own debt and I didn’t even know you could do that. Nevertheless, it seems to be what they do and its something worth contemplating the implications of.

Potential upside from The Long Term Mortgage Portfolio

An interesting sort of call option that Impac has embedded into its value comes from their residual interest in a number of securitization trusts. Before 2007 the company originated and packaged mostly sub-prime loans and sold them off to investors through non-recourse trusts. The company kept a residual interest (the equity) in these trusts. The residual interest was the lowest rung on the ladder, being the first to not receive payment in the event of defaults within the trust.

These trusts are basically securizations of mostly Alt-A loans (meaning loans where the borrower does not have full documentation of income or net worth or some other metric that Fannie Mae and Freddie Mac requires).

Probably the most important thing about these trusts is that they are non-recourse to the Company, so the economic risk is limited to the residual interest only.

A break-down of the current fair value estimate of residual interest in the trust by year (taken from the 10-Q) is shown below:

These trusts are carried at fair value and the debt associated with them is also carried at fair value. The difference between the expected fair value of the trusts (which is $5.469 billion) versus the debt (which is $5.446 billion) is $23 million.

While Impac seems to point to this number in its 10-Q I don’t think its terribly relevant. For one, the future value of the trust assets (the mortgages within each trust) are based on a lot of assumptions, including future default rates, prepayment rates, interest rates, and so on.

Probably more importantly, at maturity the debt associated with each trust has to be paid in full, not at fair value. While the overall fair value of the trust assets is a little less than $5.5 billion, the outstanding principle balance of the debt is $9.1 billion. So clearly the debt outstanding outweighs the trust assets. Nevertheless, the trusts are clearly not all a worthless asset. In the second quarter the company collected $4.4 million in cash from the trusts, representing residual interest payments from those trusts that are presumably in a strong enough position to meet the collateral requirements that must be met before cash is paid to the residual interest holder. Value is being realized and the potential for more value to be realized exists.

What I think is worth highlighting is that the future cash flow potential of these residual interests is basically a pure play on the US housing market. Less defaults, stronger cash flow performance from the underlying mortgages, and Impac stands to take in a decent amount of cash from these trusts. If housing goes down for a triple dip, well then you can probably write them off to something pretty close to zero.

Conclusions…

The stock is a bit of a flier, no question about it. The market capitalization is miniscule, the analyst and brokerage following is non-existent, and the disclosure is not as complete as I would like it.

Nevertheless, the industry is right and, if my thesis about the housing market bottoming and potentially surprising to the upside pans out, the timing is right. The company, if you ask me, is doing exactly the right thing at the right time by building its origination business and retaining as much servicing as cash flow will allow. I’ve taken a position and added to it once. If it continues to play out as it appears to me it could, I will continue to add on the way up.

I think its pretty likely they are going to raise capital here at some point soon. You probably already listened to the AGM where he said flat out that was part of the plan. It may be after one leg higher if we are lucky. I guess it depends the price of the capital, how much they raise and what are they going to use that capital for. At the AGM Tomkinson said that if they raised capital, they could increase their warehouse lines by $70 million for every $700K they had. Right now warehouse capacity is about $140 million (top of my head) and so you could raise $1.5 million and double that. I would be ok with that.

I agree they will raise soon. Just trying to figure out whether it’s a good buy here or wait for it. I think it’s kind of bad form to come to market RIGHT after a large pop in a stock. Would be viewed with skepticism so they might wait for a couple months letting the stock drift up. On the other hand they seem VERY eager to grow on the calls so I don’t know if the have the patience to wait. I also think if they come to maker they will raise more than 1.5MM just based on their optimism. I may dip my toe in here a little bit.

And wanted to thank you for your hard work. I have agreed with many of your ideas and even bought a few after doing the DD. I was also the one who was arguing with you about PHH on Seeking alpha lol. I mentioned the next quarter was key, they putbacks decreased, so I did indeed buy in.

It does seem like a the preferred holders got a poor deal in retrospect, but its easy to judge these things after the dust has settled. At the time the mortgage market was in full-implosion mode and most of Impac’s competitors have since gone bankrupt. And there were some ~70% (top of my head) of holders that agreed to the terms.

But as I said, I have not investigated this aspect as much as I need to and particularly how the law in California would treat this sort of litigation.